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Property funds

Offshore investors have been ploughing money into property and reaping rich rewards but the introduction of real estate investment trusts in the UK has brought competition. Tiffany Hancock takes an overview of the property investment market

The statistics say it all - in 2001, there were only three property funds listed on the Channel Island Stock Exchange. Fast forward to 2007, and there are 117 funds listed.

The last five years have seen most property investors laughing all the way to the bank. As property prices have soared, so have the number of property funds, all keen to take advantage of opportunities on offer.

Offshore property funds have long had an edge over onshore offerings because of tax advantages. The offshore structures of the Channel Islands and Isle of Man allows investors to profit from properties held in the fund with- out having to pay corporation tax and capital gains tax.

However, the introduction of UK real estate investment trusts (Reits) in January of this year has established some competition. As Vernon Breese, business development director at Standard Bank's fund administration team, says: "It's difficult to say that there is now a massive difference from either a regulatory or tax perspective."

Instead the key advantage offshore structures now boast is one of flexibility. As Iain Fairbairn, fund manager at Armstrong, says: "The Reit rules in the UK are very prescriptive but the offshore structures are far more flexible which means you can run your property fund how you choose. You can play around more with debt structuring or how much of your income you distribute."

As Breese points out, Jersey has a highly-experienced skill base that knows how to facilitate unusual schemes which "aren't exactly vanilla in style and structure".

Fragmented market

Offshore property funds are hard to stereotype. They range in size, strategy and areas of interest. By and large, the UK property market is still considered a good investment, though as Jason Baggeley, fund manager at Standard Life Investments (SLI), says: "Investors have to realise that the last three years have been exceptional - returns aren't going to continue at the level they have done. People have got very used to double-digit returns (16 or 18% year on year) but that's not normal and well above long-term trends. Returns are going to be more muted but we're still expecting just over 6% per annum."

Baggeley is optimistic about the returns from Central London offices but pessimistic about the future of high street retail outlets, especially in smaller, more secondary towns. He partially attributes this to the boom in online shopping and the penetration of broadband into homes nationwide.

Fairbairn agrees that there has been something of a power shift from high street landlord to tenant. He says that town centres must work to improve their appeal to shoppers to stop shops moving out of town and cites Birmingham as a prime example. He says: "Birmingham's retail centre is thriving and nothing is moving out of town - if anything, shops are clamouring to get in. The key is blending. The centre is not only retail outlets but a mixture of leisure facilities and apartment blocks as well." Fairbairn believes that Birmingham may well pave the way for the future as people won't have to make special journeys to the shops.

The UK housing sector has seen incredible returns over the last few years but Fairbairn predicts that it will slow in the near future. However, he believes a collapse is unlikely for three reasons. Firstly, the number of single parent families is rising. Secondly, immigration is high and likely to continue and thirdly, new houses are being built at a slower rate than the population is expanding.

Outside the UK market, Eastern Europe is one of the hot topics of the day. "Eastern Europe is the area of biggest development at the moment, particularly the Russian federation, Ukraine and Bulgaria. It's a prime interest for Standard Bank," says Breese.

Others are being more cautious. Aljoscha Haesen, fund manager at Forsyth Global Property fund, says: "While there is a demand story with no excess supply of properties in the short-term, we feel that share prices more than reflect this. Looking at the medium-term, we fear that there will be a substantial level of oversupply which means that neither property market fundamentals nor valuations are compelling. We're not buying any Eastern European property."

Asian exposure

Instead, Forsyth has been steadily increasing its exposure to Asian property, particularly in Japan, Hong Kong and Singapore where Haesen says: "A lot of supply is going in but demand is still stronger than that. In Tokyo, the office market is especially tight - less than 3%."

Standard Bank is about to launch a Chinese property fund but as Breese says: "There are restrictions and therein lie the challenges to overcome. You'd think the problems would be time difference, law and language but that's not always the case."

The Middle East is another area of interest for Standard Bank, particularly Dubai, both as a place to invest in and also as a source of investors. Property lends itself to Sharia law as the lion's share of property income is not derived through interest.

The US is an interesting topic for property funds at the moment. Haesen says: "The 'meltdown' in the US sub-prime market caused sentiment towards US property stocks to weaken but investors should be aware that property funds are biased towards commercial rather than residential property (which is the part of the market affected by the sub-prime issues)." Although Haesen expects US economic growth to be dented by a slowdown in the housing market, he argues that, overall, economic expansion continues, albeit at a slower pace, and believes that the fundamental backdrop for commercial property remains sound.

The boom in property funds has led to a number of developments. Fairbairn talks of "increased segmentation". He says: "A decade ago you'd have one of the large instit- utions running a UK commercial property fund. Today is very different. What you're seeing in property is what you see in equity where you get small cap and large cap funds. Investors are far more selective today and will pick and choose between funds that specialise, for example, general office space or pubs or student accommodation."

Ethical inclination

One new niche area is property funds with an ethical bent. The Armstrong Residential High Yield fund is described by Fairbairn as having a diversified strategy with a residential focus and an ethical mandate methodology. So far the fund has received a lot of interest and Armstrong is planning to launch a similar fund (albeit focused on regeneration) in the near future.

Armstrong approaches the fund from two angles, one being social responsibility and the other being environmental friendliness. For the former, much of Armstrong's investment has been in social housing. The latter has involved a number of issues, including how properties are powered and how eco-friendly the building materials are.

"We tend to use windpower or alternative energy sources for all our large multiple occupancy places. There are lots of new developments which are carbon neutral and the [UK] Chancellor is talking about giving incentives to get people moving that way," says Fairbairn. For Armstrong's investors, profit-making is clearly their main goal but the ethical slant is viewed as a definite bonus.

An offshoot of the increased segmentation is that funds of property funds are likely to develop. As a ways of spreading the risk, they are likely to be attractive to investors and as Fairbairn points out: "The opportunities of greater liquidity mean there's more choice to create an interesting fund of funds."

The future is also likely to see more open-ended products coming to the marketplace.

"Open-ended products are more accessible for a lot of investors as they deal with shares rather than physical property," says Haeson. "It really comes down to how much liquidity you want though." Open-ended products are more likely to appeal to retail-type investors. Baggaley says: "Over the last five years, there has been an increased awareness of trying to cater to individual retail investors." However, he adds: "There needs to be a leap in the framework to protect them."

The way forward

Property funds in the Channel Islands and Isle of Man have come a long way over the past few years but further challenges lie ahead. As the European property market attracts attention, Luxembourg-domiciled funds will be a key source of competition. Fairbairn also points out that the Channel Island funds are non-Ucits funds - meaning that they are not recognised by the EU - which restricts a number of vehicles from investing in them. Further European countries (such as Germany) bringing forward Reit regimes will also be a cause for concern for offshore property funds as there will be a greater opportunity for people to invest elsewhere.

Overall though, the outlook is bright for offshore property funds. New property funds are currently being created and there are increasing areas of interest to invest in. Fairbairn says: "The Channel Island Stock Exchange (CISX) in terms of cost is phenomenally better value than what is on offer in London. Providing it keeps its high standards and ensures it avoids any disaster companies, it has a good future." n